più rilevante del rapporto Debito/PIL

[dukeMida]

September 02, 2011

By Arnaud Marès | London

Does it matter whether government debt is risk-free? This, in essence, is the question being raised by the downgrade of the US government by S&P and, much more importantly, by the decision of European governments to effect sovereign debt restructuring in Greece in the form of ‘private sector involvement'.

The answer is yes. It matters considerably, we think. The risk-free nature of sovereign debt and its resulting safe haven status are in our view instrumental to the ability of governments to use fiscal policy counter-cyclically as a macroeconomic stabilisation tool. If government debt is deprived of its safe haven status, then this pushes us back towards a ‘pre-Keynesian' state of the world where fiscal policy is neutral at best (US), and more likely pro-cyclical (Europe). Against a backdrop of slowing growth in advanced economies, the consequences are likely to be serious.

In this note, we provide our interpretation of the ‘consequences of Greece', both in Europe and more globally. In Europe, we believe that the decision to resort to private sector involvement in Greece without having first put in place credible arrangements for the funding of governments set in motion a chain of events that extended the debt crisis to Italy, Spain and to a lesser but nonetheless significant extent France. We think that it also makes an acceleration of the process hinted at by Angela Merkel and Nicolas Sarkozy (fiscal integration accompanied by common bond issuance) the only genuinely stabilising outcome for Europe. If that does not happen, the most likely alternative is in our view sooner or later a ‘debt jubilee', by which we refer to a wave of public and private defaults, with all the economic and social consequences this entails.

Towards a world of fiscal dominance. More globally, we believe that the deterioration of government credit results in a form of fiscal dominance, whereby we mean that the fiscal situation constrains the course of monetary policy, possibly for a long time.

What happens in Greece does not stay in Greece. The relevance of what happened in Greece does not flow from the size of the country or its role in international trade and financial flows. Both are minimal. It does not flow either from the exposure of foreign institutions to the Greek government. That is manageable. Rather, the global relevance of what happened in Greece stems from the fact that it officially put an end to the notion that sovereign debt is risk-free.

‘Private sector involvement' in Greece is indeed effectively the first case of sovereign debt restructuring in advanced economies since the Second World War. Even though not all creditors will suffer losses, many will. The fact that private sector involvement is both partial and ‘voluntary' is relevant to the CDS market - avoiding default in a technical sense - but does not fundamentally alter the economic reality of the precedent set in Greece.

Sovereign debt is officially no longer risk-free. It is significant that this restructuring was not a unilateral decision of the Greek government, but was imposed by another European government (Germany) and endorsed by its peers. This makes it an official validation of the notion that sovereign debt is not, and in the view of some at least should not be, risk-free.

It would be tempting to believe that events in Athens are idiosyncratic in nature and carry little relevance for other governments, inside or outside Europe. This is the line taken by European heads of state and government, who stated on July 21, 2011 that:

"As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature (...)".

The credibility of this statement relies on three assumptions: first, that Greece was an idiosyncratic case because Greece was insolvent while other governments are not; Second, that other governments will be able to fulfill their obligations because they are not only solvent but liquid; And third, that the line drawn between Greece and other countries is credible because governments said so.

The market was not convinced. Neither were we, for the following reasons:


Government solvency is a blurred concept. For governments with high levels of debt, the concept of solvency is very sensitive to the government's cost of funding, and therefore to swings in market confidence. What makes a government solvent is its ability to stabilise its debt (as opposed to the level of debt in itself). This, in turn, depends on the ability of the government to generate a sufficient primary balance, which can be expressed as follows:

Primary balance / GDP ≥ ( i - g / 1 + g) x debt / GDP

Where i is the average interest rate paid on the debt and g is the nominal rate of growth of the economy.

What this relationship emphasises is the importance of the interest rate paid on the debt. All other things being equal, a higher cost of funding raises the ‘fiscal hurdle', i.e., the required primary balance, in proportion to the initial level of debt. The higher the interest rate, the higher the likelihood that the fiscal hurdle becomes politically insurmountable, which in turns justifies a higher risk premium in what becomes a vicious spiral. Conversely, a government with even a very large level of debt can appear entirely solvent if funded cheaply enough, a point to which we return below (for a longer discussion of this point, see Sovereign Subjects: Sense and Sustainability, November 5, 2010).

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Fiscal dominance exists in fact across advanced economies. This form of fiscal dominance, we believe, is not a European but a more global phenomenon, illustrated by the situation of the US. It is indeed in our view only the dominance of fiscal authorities over monetary authorities which guarantees that - unlike what happened in Europe - the US government remains entirely (credit) risk-free.

To illustrate this point, it suffices to consider the debt ratio that we consider much more relevant than debt/GDP, the ratio of a government's debt to a government's revenues. This ratio approximates 360% in Greece and 315% in Ireland. It stands at approximately 325% for the general government in the US, much higher for the sole federal government (for the sake of comparison, it stands at around 170% for France, 190% in Germany and 220% in the UK). What, then, makes the US government entirely solvent, while those of Greece or Ireland may not be? The answer, in our view, lies less in the revenue-raising capability of the US government and more in its low cost of financing, engineered by a very loose monetary policy. For a government with short-dated debt (especially when taking into account the effect of past quantitative easing operations), there exists a relationship of causality from the monetary policy stance to sovereign debt dynamics that results directly from the formula presented earlier.

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Morgan Stanley - Global Economic Forum